B (2:50)

And that's a bit of a shift too, because over the last, say, 15 or so years, electricity costs have been going up roughly in line with inflation. Inflation. So this is a bit of a step change with electricity costs now starting to rise at a pace that runs ahead of inflation. And that means, you know, inflation itself already hurts, but now your electricity bill is going up even faster than that.

A (3:10)

So on this week's show with all that preamble, we are going to talk about the biggest factor driving electricity price inflation, why prices are going up so much around the country, and the surprising policy driver of that inflation. The aspect of how electricity prices are set that you may not be thinking about, but that is going to be key to untangling the knot of rising demand for electricity on the one hand, and rising costs providing electricity on the other hand. I think when you see discussion of rising electricity prices in the popular press, you know, these accounts often focus on common sense, supply and demand style, drivers of higher prices. They talk about how we're building out more data centers. They talk about EVs, they talk about how it's getting harder to build new renewable energy across the country. All of those things are true, by the way, and it is true that electricity, on kind of a broad sense, does respect supply and demand dynamics. But electricity prices are not set the same way that say gasoline prices are set. Electricity prices are weird. And not only are they weird, but ultimately about half your bill comes not from the actual supply and demand of generating or producing electricity, but the last mile of the electricity grid, the work of getting electricity to your house, the poles and wires themselves, which everywhere in the country are operated by some kind of monopoly utility that is in charge of getting electricity to your door. When you look at the biggest drivers of electricity price increases across the country, especially on the investment side, almost all of it is coming in what's called the distribution grid. This is the local power grid, the poles and wires that deliver electricity to homes and businesses. And according to Lawrence Berkeley National Lab, there's actually like three things driving this. It's the poles and wires themselves, undergrounding equipment. So you know, poles and wires, when they're effectively underground and transformers, those three things basically are driving the surge in capital investment from utilities. So today we're going to talk about two things. First of all, how poles and wires are driving a surge in Americans electricity bills around the country. And second of all, the policies that could fix that surge. Surge, why? The fact that electricity is weird means there might be some uncommon or unconventional or unpredictable ways to fix its inflation problem. Okay, so Jesse, maybe let's start here. Like, can you just give us an intro to like, what the distribution system is?

B (5:46)

So we, this is probably the part of the grid that we are all most familiar with because it's the part that we see every day, poles and wires running down the street. The transformer outside of our house with the wire dropped to serve our electricity demand in our own homes. It's the sort of last mile delivery component of our continent spanning electricity system. Generally speaking, we think about those networks as divided into two chunks. The transmission system, which is where we pump the voltage up to very high levels, 100 kilovolts or above. We do that because it's much more cost effective to transmit power over long distances at high voltage because the power is equal to the current times the voltage. And so you can move a lot of power without too much current if you can increase the voltage on those lines. Think of voltage like the water pressure that's pushing the power down the line. You basically have a high pressure line. And so we want to do that for long distance transmission, but we don't. We can't consume electricity at 110 kilovolts. That would blow up every device in your house. Instead, we consume electricity at 120v typically, or 115v for most consumer devices. Some things like a electric washer or your EV charger might be plugged in at 220 volts. So in kilovolt, thousands of volts down to a few hundred volts. And so what we do is we step down that voltage as it gets closer to where we live. First, a transformer, a set of transformers at a substation, a whole bunch of transformers where a large high voltage transmission line or two will come in. That voltage will get dropped down and it will get sent out at tens of kilovolts, probably to different parts, to sort of primary distribution lines that spread out through a town or a city. And then they'll get stepped down further to the final lines that are usually single kilovolts that run down the street or under the street in some cases, where the city is dense enough that it makes sense to underground wires, or it's wealthy enough that they don't want to look at it and have gotten the utility to put it underground. And then it hits a final service transformer that drops it down to the 220 volt service that comes into your house. So it's all of that from the primary substation where the long distance transmission lines drop off the power and it steps down to local delivery volts voltages all the way to your home or a business in the vicinity. And that distribution portion of the network is far more extensive and expensive than the transmission system. Even though each individual transmission line itself could be like a billion dollar 100 million asset, there's comparatively fewer transmission lines. A single large city has as many distribution lines and assets as the entire continent scale transmission system. And we have of course, many of those distribution networks, hundreds of them all over the country. So they're their own complex beasts, each one of them. And they have, there's a lot of cost there, there's a lot of copper and aluminum and poles and maintenance and equipment. And all of that adds up to a big chunk of what we pay on our electricity bills. If you look at the electricity bill, it's usually listed as something like delivery or sometimes networks or sometimes distribution. That's the part you're paying for all of those holes and wires, service trucks and technicians.

A (8:48)

In some ways, it's a classic story about the American economy, right? Like the big giant pieces of infrastructure are very expensive, like long distance transmission lines, but actually where all the wealth is is in the small infrastructure or the comparatively small infrastructure that at great scales distributes resources to every household in the country.

B (9:04)

And I should say there's different across the country. There's a sort of different, many different configurations of how the electricity sector is structured, sometimes overlapping in the same place. And so in, in a lot of parts of the country, the utility that's responsible for distribution is also responsible for transmission in a given territory. So a chunk of that big continental grid is also their responsibility. That's the case of say, a California utility like PG&E or a local New Jersey utility like PSEG. They're both a transmission and distribution wires company. In other parts of the country, particularly those served by rural electric cooperatives or local municipal utilities, they may do the distribution network part. And then there's some other entity that is delivering the power sometimes like a federal power marketing agency like the Tennessee Valley Authority or the Bonneville Power Administration, or a cooperative of lots of those smaller local municipal or cooperative utilities. So you might see different entities playing this role, but it's one of the most essential functions in the grid. And it's probably the person responsible for your bill. At the end of the day, when you actually pay somebody, you're paying the company that does this distribution service and then even in a market where it's restructured, where there's a competitive generator and markets, whatever, they're collecting that money and then sending it on to that competitive market on your behalf.

A (10:23)

This is how my bill works in New York City now. Con Ed is my utility and it is part of the New York ISO. But it about half my bill now is transmission distribution. I do feel like the way that we talk about transmission distribution is feeding into a talking point that is wrong and that I want to briefly address. So the fastest growing part of Americans bills is this T and D section, transmission distribution. I think it's often called T and D. And what you hear from folks like Energy Secretary Chris Wright is that this, these rising T and D costs are driven by renewables, the rush to get more renewables on the grid. And while there's a very weak relationship between electricity cost inflation or electricity costs overall and renewables penetration into a grid.

B (11:14)

It'S actually a negative relationship.

A (11:15)

It's a negative. Exactly.

B (11:16)

Meaning the more renewables you have weekly is correlated with lower retail prices and wholesale prices.

A (11:22)

Yes, I should have said there's a weak negative correlation. It is also the case that in some states that have had very high renewables grids, mostly California, the T and D portion of the bill has shot up. And I feel like this is a bit of a misnomer and this is the fact that we talk about transmission distribution like in the same breath, because it's the one section of most people's power bills is driving this wrong conclusion. Because when you look under the hood at where all the increased T and D spending is going to, and I'm doing air quotes there, when you look under the hood, all the quote, increased transmission distribution, unquote spending is going to, it's all going to distribution or it's almost all going to greater distribution investment.

B (12:04)

And that's just a function of the fact that if you look at the T and D chunk, 80 to 90% of that is distribution and only 10% of it to 20% of it is transmission. Transmission is very cost effective because of the economies of scale involved. And so even though they're moving the same amount of energy around. Right. Got to go through the transmission system before it goes to the distribution system. Those transmission lines are just much more cost effective because of their scale. And so even if you could demonstrate that renewables were driving up transmission costs, and there is a case that especially for wind power, we need to build more transmission to accommodate that wind so we should be thinking about the total cost of both connecting the wind to the grid and its cost of building the wind farms. That couldn't possibly be what's driving up our bills because the distribution network is unaffected by that. It's a whole nother piece. Unless you're talking about rooftop solar, I suppose, but not the utility scale renewables that this administration is really targeting and starting to demonize.

A (12:54)

Well, this is, but this is, I think exactly kind of where the wonky habit of referring to this as T and D or transmission and distribution simply because it's a part of people's bills and is actually driving the misnomer because that allows renewable opponents like the current administrator, like officials in the current administration to say, oh well, the transmission and distribution section, the wire is part of the grid, is the surging part of electricity costs. This is driven by renewables. And that kind of does cohere to a mental model people might have of like oh, you have to build a lot of solar farms everywhere or oh, you have to build a lot of wind farms everywhere. They're distributed over the landscape, unlike a single big power plant or something. And therefore that is driving up transmission spending. And indeed for renewables, as Jesse was saying, you do have to build more transmission. But where you look at the actual increase in prices is coming from in that T and D section of the bill. It is not at all that story. It's all coming from distribution.

B (13:53)

It's certainly not coming from long distance transmission because we're not building any long distance transmission. Right. And that's the other big problem is we have not been building transmission at anywhere near the pace that we a have historically during periods when demand was growing rapidly to tap into the best resources around the country. But also than we should be if we were to try to tap into American renewable energy resources, that could lower consumer costs. The transmission we are building is mostly also local short distance reliability related upgrades that the transmission utilities are able to build with much less regulatory oversight. And we'll come back to the role of regulation I think in a bit. But yeah, it's totally not that.

A (14:29)

And I just wanted to make the point of how much, especially post Covid transmission and distribution inflation, this T and D inflation has been driven almost entirely by distribution. So in 2019, about 37% of utility capital investment went into distribution. In 2023, which is the most recent year we have data for nearly half, it's like 49% of all utility capital investment went to distribution. So there has been this huge surge in utility investment in distribution basically entirely since the pandemic. This is all from a Lawrence Berkeley National Labs report. And when disaggregated, where all this surging spending was coming from, it actually is in the distribution part of the distribution network itself. Because I've also heard some renewable opponents say, oh well, is that going into meters? Like how much of this is coming from rooftop solar? Is it going into the equipment you need to like service rooftop solar? And where it's going is truly about $6 billion more from 2019 to 2023 went into overhead poles, towers and conductors, about $4 billion more went into undergrounding equipment, and then another couple billion dollars went into transformers, which have been basically in critically short supply since the pandemic, which to some degree have just exhibited kind of classic equipment and shortage inflationary price dynamics since the pandemic, no matter what. So it really is going, you know, where surging utility capital investment is going to, is truly in the distribution side of the T and D side of your bill. This is a somewhat different problem than maybe electricity price wonks have been spending the past several decades thinking about. Or at least it's a different problem than let's say our current set of policies to deal with the power grid are prime to think about. And now I'm going to be in the classic position of doing potted history while I talk to an actual expert. But my understanding of the classic set of changes that were most recently made to the power grid were to deregulate aspects of the power grid, to shift to this market based system, to break up monopoly utilities that existed across the country into basically like a two part market where you have on the one side one set of companies that deal in the generation side of the market. They're the ones all focused on producing power and they're competing in daytime power markets. This is the case in Texas, in the Northeast, in out west, in parts of the Midwest. And then they send the power ultimately to these local T and D utilities that are responsible for getting power the last mile to your door. That was built for a world where what we were trying to do was drive the generation side of the bill down because we're applying market dynamics to the generation side of the bill. In a world where the monopoly part, the T and D part of the bill, is the part of the bill experiencing price inflation, that is just not the world. That kind of policy, at least in the United States, has been thinking or geared for over the past few decades. Is that wrong, do you think?

B (17:37)

No, I mean the restructuring of electricity markets is exactly, you said it involve really trying to discipline utilities and their construction of big generators. This is coming out of the era of cost overruns for nuclear power plants and coal power plants and others, and a time when the vertically integrated utilities did everything right from generation to distribution. Again, that's still the case in parts of the country, but then the parts that restructured. The goal is to say, look, these generation costs are getting out of control. Utility has no incentive right now to be efficient at building out generation. That's also still true for transmission and distribution, as we'll talk about in a minute. And so we should discipline those markets with competition. And because of the advent of combined cycle natural gas plants and wind farms that were small enough in scale that individual investors, independent power producers could come into the market and compete. You know, you didn't have to build a city scale nuclear power plant, gigawatt scale, to be cost effective. You could build a 200 megawatt combined cycle gas plant for only a billion dollars and still get in the game. The idea was to open up that market to competition. And that competition would drive the existing utilities to be more efficient with their remaining generation fleet and it would allow new entrants who could do it for cheaper to come into the market and provide lower cost supply. None of that affects the distribution network or the incentives of the utilities that are managing those distribution networks. In fact, they were carved out of that pict of the original vertically integrated utility and left alone as a regulated monopoly wires company with all the same incentives to continue to basically build capital investment as their way to make money without any competition, right. To try to discipline them.

A (19:23)

Right. So how do these utilities make money? Because right now, right, like everyone in the United States basically does, interface with some kind of monopoly utility for their electricity in the Northeast, in California, in the Pacific Northwest, in the Midwest, you interface with the monopoly utility and it's just in charge of the of the transmission distribution system. In the Southeast, your monopoly utility is responsible for transmission, distribution and generation because they never set up deregulated power markets. But like everyone in the US has some kind of monopoly utility handling part of their power bill. Either it handles just the T and D section or it handles T&D plus generation. Mostly in the Southeast, where Duke and.

B (20:07)

Southern Company and parts of the West.

A (20:09)

End and parts of the west, there is an entity allegedly negotiating on your behalf with the utility about what the utility can charge you, right? And that is this quasi judicial body of state officials called your public utility Commission or the Department of Public Utilities or something that regulates what the monopoly can do and what it can charge customers. And they want to make long term decisions. They're supposed to make those long term decisions in consultation with the commission. And then also before they raise rates, they're supposed to come back and get the commission's approval about how and when they can raise rates. And in theory, that is how these utilities are regulated. They are doing all of this under the aegis of this Public Utility Commission. But can you just talk a little bit about where this falls flat and why this may not be the right approach for actually constraining costs?

B (21:05)

Yeah, I mean, the best way to think about this as a contract between the utility commission and the monopoly utility. And that contract effectively specifies how the utility makes its money. And to help think about that, let's think about what would happen if you were remodeling your house. You go out and you get some bids from different contractors. Except in this case there's only one contractor because it's a monopoly. And they tell you, you know, it's going to cost me $50,000 to put in your new kitchen. That's my estimate. But once you hire me, you're going to pay me whatever it ends up actually costing in terms of time and materials, plus my profit margin. On top of that, want to sign that contract? If they're the only option, you might have to sign that contract. But in any other market context, you would probably do one of two things, right? You would go out and you would get a bunch of other bids from different contractors who could compete with that one to see who's going to offer you the lowest cost. Or you would set up something like a fixed price contract to say, okay, well, you think you can build it for $50,000? Fine, let's sign a contract for $50,000. And if it costs you less than that, you keep the extra. And if it costs you more than that, that's on you. But I'm still just paying you $50,000. Why am I talking about contracts? Well, that's basically what the public has done is sign a regulatory contract with these distribution utilities, these, that determines how they make money through that contract. And that contract is effectively a cost plus contract. It's we are going to give you a regulated return on any capital that you invest, plus pass through of all of your operations and depreciation and taxes. That's what they're collecting from you is basically those four chunks of money. It's a annualized return on all the capital Equipment they've built and invested in, that's all the wires and poles and everything else, how much they spend on operating and maintaining that, those poles and wires, the depreciation or sort of gradual replacement of those existing equipment and the taxes and things like that that they have to collect to pay for to the government. And they make money in that environment by basically investing more because they're getting a return on that capital invested. Everything else is basically a pass through of expenses straight to us. And so this provides a direct incentive for utilities to build. That was the original intention. And that, you know, when you were talking about building out the power grid to begin with, that's exactly what we wanted them to do, was build, build, build. Maybe with demand growth, again, that's something we still want them to do. But I think in the current era we also probably want them to build cost effectively. And the only disciplining of cost efficiency that happens in this environment is that the regulator has the opportunity to disallow recovery of costs that are not prudently incurred. Meaning if the utility does something that's obviously not smart, the regulator won't necessarily pay them up. So that part of the cost they'll have to eat. That, it turns out, is a lot easier to determine when you're talking about a single large investment like a nuclear power plant or a big transmission line than it is millions or thousands of different small upgrades of one wire here and one service transformer there and one truck roll over there. And so in practice, there's very little cost discipline actually applied through this prudency review in the case of distribution networks. So it's really closest to a cost plus contract that you might sign with a contractor or the federal government might strike with a provider of aircraft or destroyers for the Navy or something like that.

A (24:28)

Totally. And kind of the way this process works is the utility gets to charge a fixed amount of profit when it builds stuff. And so it can go out, it can do a big project, whether that's a distribution, or in these monopoly utility states like a power plant, and it can build, build, build, run up some costs, and then it comes back to the utility commission and it basically gets to then take the costs that it incurred during whatever big building project it just did, add a fixed amount of profit, which is decided by the commission on top of that cost, and then charge that to consumers as part of our electricity rate package. Is that a fair description?

B (25:07)

Yeah, that's about right. I mean, basically say you build a million dollar distribution transformer, customers aren't Paying a million dollars for that transformer right away, because that transformer is going to last a long time. Basically, you're paying for a mortgage on that transformer, right? You're paying for the principal over time. That's the depreciation component. And then you're paying for the cost of the utility, raising money, capital to invest in that transformer. And in order to allow the utility to go on the market, the equities markets and the debt markets, and raise the capital it needs to build that transformer for you, the utility gives them a regulated return on their investment. And that return pays for the equity to their shareholders that they raised and the debt that they took out to finance part of that project. So it's basically paying the mortgage. And the tricky thing here is that the regulator has to get basically estimate what is a sufficient return on capital that given the risk profile of a utility, which is relatively low, given that their returns are effectively guaranteed, in most cases, that is sufficient for that utility to raise the money it needs to do the job we want it to do, which is to build and maintain the distribution network. You can think of this as a bit of a dilemma for the regulator, right? Because if you set that return on investment too low because you're trying to save money for ratepayers and lower the cost on the utility bill, and the utility can't go to the equities market and raise money, then it can't do its job. And we need the utility to do its job right? And so what ends up happening is that the regulators tend to set that value a bit too high, because it's better to set the value a little too high and allow the utility to make a little too much money than for them to not make enough money and go bankrupt or simply be unable to make prudent investments in the grid that we need them to make to keep the distribution functioning and safe. And so that leaves this little extra profit margin above and beyond. It's like a premium value above and beyond what a similar thing would cost in the equities market, where that return on investment is competitively determined. And that makes utilities a really sweet deal. They look good to investors. Investors want to pour more money into the utility to capture that kind of slightly above market return, given their risk profile. And in order to invest more money, the utility has to spend more capital, it has to invest more capital expenditure. And so you get this whole cycle that is basically driving the utility to build more capital and add more capital to their rate base so they can get more investment and grow their company and return these slightly above market returns to their shareholders.

A (27:42)

I always think of Warren Buffett here because what does Warren Buffett say about business? He likes businesses that have a moat. They have some factor that protects them from other businesses. And sometimes that moat is their operational excellence, but often it's some other element. I mean, he has bought patents, maybe patents, right. He's bought a lot of Apple because he feels like the Apple ecosystem has a ton of lock in. But he's also Berkshire Hathaway also bought.

B (28:06)

It's a big utility.

A (28:07)

Big utility. Yeah, exactly. Owned a lot of utilities.

B (28:10)

Because you can't get a better moat than being a franchise monopoly where literally it is illegal to compete with them. Right. Where the only people that can run wires are the utility. Maybe as a brief aside, we should say that, that we want there to just be one utility generally because there are big economies of network scale and scope. The fact that you don't want six different people running distribution wires down the down your street and only one of those sets of wires stops up at your house and the other one stops at the neighbor's house. That's how the original grid started to take shape in the days of Edison and Westinghouse. So we basically decided to grant franchise monopolies to an individual utility for a given service territory or geographic territory so that they could accomplish those economies of scale and network scope and deliver a lower cost product for us than having five different smaller companies in the same market. But if you allow somebody to be a utility, they'll charge whatever they want unless you subject them to regulation. And so that's why we have to regulate these monopoly utilities.

A (29:07)

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B (30:51)

So that was an interesting case where basically what we did was we allowed for competition between different networks. So at the time it was fiber, right, Your phone network, cable and satellite. And we said, look, there's multiple ways to provide this service. They're not going to run parallel wires on top of each other. Right. They're different services, different networks. We'll let those network companies compete with one another to provide the service to you. And then we're going to stop regulating so closely anyway. And there's still some economic regulation there, what they charge you so that they have an incentive to compete and provide a better service than the satellite or the cable provider. Now, cell phones and 5G Internet have entered the picture. Have a whole other set of networks as well that are competing, that are even less capital intensive because they're radio waves and not fixed capital. Right. Wires and cable, we can't. We didn't do that in electricity. Right. There wasn't wireless electricity transmission, not yet anyway. And so they're still regulated kind of the same way they were in 1926, right under this kind of cost of service regulation or rate of return regulation, as it's often called.

A (31:54)

And I do want to also evince some sympathy here for the commission, who, as you said, are giving this extra premium to the utilities. But on the other hand, they're dealing with the kind of poison set of incentives where, you know, in 40 out of the 50 states there's some kind of political appointee and they're dealing with this dynamic where, like, either they charge everyone a tiny bit too much on their power bill, which results in a small amount of kind of premium profit for the utilities, or they watch the local utility go bankrupt and. Or run into reliability issues, at which point people experience blackouts, and then it's really, really costly for the economy.

B (32:34)

No, it's the rational thing. For them to do it's. We just call it a moral hazard problem, right. Where it's sort of everybody's acting under their appropriate incentives to do the smart thing, which is that the utility is being told the way you make money is by investing in stuff and building capital. And the regulator is saying, look, I want the utility to be able to invest reliably. And I know that if I set the rate of return too low, that's going to not happen. So I'm better off setting it ideally exactly right. But if I have to err on one side, I want to set it a little too high. The big question is how do we make sure we're not setting it way too high? Right. That's the first question. And then the second is if the utility basically has full pass through of their costs, with the exception of what the regulator deems imprudent, what is the incentive for the utility to actually be cost effective and efficient in providing the service to you? Right. What's to make? The classic incentive is to like gold plate everything. Right. And make everything extra redundant and super reliable because they make more money if they do that than if the service is a bit more efficient.

A (33:35)

And it does seem to me like these are really important questions because as I've been reporting and writing on why electricity inflation is happening, what has been striking to me is that yes, we're spending a lot, utilities are spending a lot more on the distribution system, but utilities are going to need to spend a a lot more on the distribution system. In fact, in the face of demand growth, we need utilities to do a lot more spending generally. And what has been striking, slash, worrying, slash concerning to me is this dynamic where on the one hand, yes, people's power bills are going up because utilities are spending more, on the other hand, we actually need utilities to keep spending.

B (34:18)

Yeah, we have to grow the grid to accommodate demand growth and to deal with extreme weather conditions and other challenges.

A (34:24)

And to do electrification. I mean, it's not like that's a particularly big driver at the moment.

B (34:29)

Well, in some places it is.

A (34:31)

Right, exactly. And I would add the other reason is that some, I think anti renewable officials in the Trump administration have observed that California's power prices have increased significantly. We've talked a little bit about that previously on the show. But the other reason power prices are going up a lot in California when you look under the hood, is because every kind of utility actually not only for profit utilities, but also government owned utilities, nonprofit utilities, are spending more on distribution and they're all spending more on distribution in California because think about it, they're either rebuilding the distribution grid that got burned down or they are rebuilding and retrofitting the existing transmission and distribution grid so that it doesn't start more.

B (35:15)

Burn anything else down.

A (35:16)

Yeah, exactly. Like they're the California actually faces huge, huge TND cost costs that are totally exogenous to anything happening on the generation side of its grid.

B (35:26)

And they're not the only ones. Right, that's true in Colorado and elsewhere in the West. More and more so.

A (35:30)

Exactly. And so we want other states, number one, do what California is doing so that their power grid doesn't start wildfires. Number one. But number two, we just know that demand growth has returned to the electricity system and utilities are going to have to invest for it to some degree. We want some of that demand growth and that's going to be expensive and that means utilities actually will now need to build more.

B (35:53)

Yeah. So anyway Jeff, let's talk about the right way to yeah, maybe it's fine that they are encouraged to build stuff that is what we need them to do, except that there are a lot of other tools in their toolkit now besides just building a bigger transformer. Take electric vehicles for example. There's really no reason that anybody needs to be charging their electric vehicle at the time when the distribution network is under its greatest stress. Right. A typical EV now has 250 to 300 mile range. The average American commute is somewhere between 20 and 30 miles a day. You've got seven to 10 days worth of your typical driving in that battery. There's no reason why you need to charge at 6pm on the hottest summer day when the grid is stressed. Right. And yet the distribution utility would be perfectly happy to build a larger transformer to accommodate the potential that you might do that and that they need to be prepared for that circumstance. Right. Or they could sign up with a flexible managed charging provider who then goes out and connects to all the telemetry and computing available in everybody's car and their charger and manages actively the charging of all of those vehicles so that it doesn't put any strain on the grid. There are companies like Weave Grid or EV Connect or EV Energy or others that are providing these sorts of services right now. That's an operational expenditure that will save capital expenditure. And under the current regulatory model, the utility doesn't really make any money on operational expenditures. They only make money on capital and they have no incentive really to seek the lowest cost solution to something. The only incentive they have under the current system is not to do something so obviously expensive that the utility regulator says it's imprudent and disallows recovery of that cost. Those are two very different things. Right? A systematic incentive to be efficient is not the same as a disincentive to be grossly inefficient, which is in the best case what prudency review is. And so this is not a great setup. Right. Those are, I think, the two biggest problems right there is that there's no generalized incentive to be cost effective and that there's a bias in the utilities business model towards preferring $100 of annualized capital expenditure over $100 of annual operating expenditure. All else equal, they will always prefer the capital expenditure because they get this return on investment on CapEx and not on OpEx. And so those, I think are the 2 central problems that we have to address to ensure that utilities have the right incentives to, yes, invest and build out the grid where necessary, but also to harness the wide range of operational strategies, whether that's contracts with distributed storage or incentives for people to do managed charging or time of use charging, or other strategies that smart grid related strategies that could be used to make more efficient use of the wires and poles we already have or even the ones we're going to build so that we can build less of them and lower costs over time. So yeah, that's the challenge. We can talk about solutions in a minute. But does that make sense? Sense? And I guess that's in addition to the fact that we're always going to have a little bit too high a return on investment. And in places where that return on investment has gotten way out of step with the market, with the financial markets, it does make sense to revisit those. There are some places that have not adjusted their rate of return in like decades. And that probably needs to be examined as well. So, you know, this incentive to err on the side of giving them too high a return on equity, we ought to make sure that that's just a little bit too high and not four or five points too high or percentage points too high, in which case the utility is making gobs of money for no reason. And that has happened in some states.

A (39:34)

So let's talk about how would we fix these things if we wanted to.

B (39:39)

So I think the easier one to fix is the capital bias. There's this one weird trick that they've done in the United Kingdom that we could do here as well that would at least eliminate this systematic bias towards capital expenditure over operational Expenditures like say, contracting with distributed energy resource aggregators or something like that. And that is called the totex based capitalization or total expenditure based capitalization. So remember what I said, when you invest in a transformer, you don't pay for that transformer right away. You basically roll it into this capital rate base, this accounting of all of the capital you spent, and then you pay a little bit of it off each year. You pay the depreciation, which is like paying the principal down, and you pay the return on investment, which is like paying the interest rate on your mortgage. That only applies to capital expenditure right now. And say 80% of a traditional distribution in utilities expenditures are probably capital in that ballpark and about 20% are opex. What the utility regulator OFGEM in the United Kingdom did in 2010, I think. So, you know, 15 years ago was said, hey, we are going to estimate based on all of our distribution utilities across the country what a typical spread or share of capital and operational expenditures are. And we're going to fix that ratio. Say it's 82% this year, and we're going to allow you to capitalize 82% of your total expenditure, whether or not that's CapEx or OpEx. So once we fix the ratio that we think is the general ratio, you're free to depart from that and substitute that OPEX for capex, and it won't negatively impact your return on investment. Investment, right. If you spend the same amount of money on total expenditures, you will earn the same return on your investment.

A (41:24)

In other words, basically like, here's your budget. You can make a certain amount of profit on your budget. You can spend that budget how you want. And so if you feel like you need to do more operation spending this year as opposed to fixed capital investment, you can do that operation spending. It's not going to impact your ability to ultimately make the return you've promised your shareholders.

B (41:44)

Exactly. Yep. So that's the first thing. And in the US I've heard from various regulatory lawyers that it wouldn't be possible given general accounting rules in the United States to allow for the capitalization of non capital depreciable assets, which I think is probably true from a tax treatment basis. I'm not sure that's actually true from a regulatory incentives basis because those could be different books. But in any case, even if it were, there's a way to achieve the same outcome, which is to say we will adjust your return on equity to account for any deviations from that fixed share of capital expenditure. So if we say the share is 82% ahead of time and you're going to get an 8% return on equity, if it's 82% capital expenditure and you increase that amount, we will decrease your return on equity proportionately. Or if you decrease that amount, we will increase your return on equity proportionately. And it basically allows for the utility to be agnostic to how much they spend on capex versus opex. So that would be the first thing I would recommend. That doesn't, however, address the second issue, which is that the utility is still not incentivized to save money overall. They're still incentivized in that case to spend money because they're going to capitalize some share of their total spending. They're just now able to shift back and forth between spending on CapEx and OpEx. So we need some other stronger incentives to spend efficiently. And if you can save $5 of CAPEX by making $4 of OPEX, you should do that. Right? We want the utility to do that. That's smart. And again, I go back to this prudency review process, which is really the only procedure under current cost of service regulation to implement that kind of cost discipline directly anyway, where again, the utilities regulator says you don't have a guaranteed return on investment, you have a guaranteed return on prudently incurred expenditures. And that gives them the freedom to disallow certain investments and basically say your shareholders need to eat that cost because it wasn't smart to do that is very rarely applied in the case of distribution networks simply because it's so difficult for a regulator with a small staff to monitor the thousands and thousands of regular investments and upgrades and maintenance decisions that a utility makes on its distribution network work, in contrast, say, to the like handful of large transmission upgrades they might make in a given decade, even or year, those you can very closely say, hey, you know that line you tried to build, you hired the wrong contractor, the cost blew up, they got out of control, we're not going to let you recover all those costs or something like that. But for all the little tiny decisions that distribution networks involve, it's basically impossible to directly observe the prudency of all those decisions. Was it smart or not? And so it just breaks down in distribution in a way that it doesn't, I don't think, or I mean, it can be applied more effectively in transmission and generation assets.

A (44:41)

Well, and I think this is something I encountered in reporting was that even trying to understand where when you pay more money on your electricity bill, where that Money goes or what it was paying for is a bit of a black box because utilities file their plans to regulators, regulators then review them and they review the costs associated with them. But then often there's kind of a third party arbitration step where actual decisions are made about what kind of different parts of the rate will go to different projects that's not clear to the public. And also there's just, as you were saying, dozens and dozens of projects in a way that kind of defies anyone's ability to inspect each of them.

B (45:21)

Yeah, so it might be reviewed at like the program level. Like the utility says, hey, I want to upgrade all my meters to smart meters meters. Right. But did you hire the right contractor to install smart meter number 1236? You know, like that's impossible to know in the way, you know, did you hire the right contractor to install your billion dollar transmission substation. Right. That you could probably pay attention to. And so it's just very difficult to apply that prudency concept. So there's another approach that again has been used in the UK forever from the very beginning of when they liberalized, meaning sold off their publicly owned utilities in the 1990s and started regulating private utilities. And that is variously called incentive regulation or revenue cap or RPI minus X. RPI is the inflation indicator in the uk. So it'd be like CPI in the US with the idea that you would you want the utilities cost to be adjusted for inflation minus this X factor, which is the efficiency improvement they should make every year. All of these are basically, excuse the Latin, ex ante regulation or before the fact. Right. The idea is I'm going to estimate what the utility should be allowed to spend before they go and do it. And then I'm going to fix that amount and I'm going to say, okay, if you spend less than that or more than that, we're going to share that savings or cost overrun at some percentage between your shareholders and the ratepayers. So the most extreme form of this would be like the fixed price contract. I'm basically saying I'm going to pay you X billion dollars for the next three years of operating your utility. If you can do the job for x billion minus 2, you keep that too. You can adjust that sharing ratio however you want. It could be 50, 50 between shareholders and ratepayers. Or I guess cost of service is sort of the extreme other side of the equation where the sharing factor is, you know, zero. All of that cost is passed through to customers. None of it is passed through to ratepayers. And so you can fall anywhere on that spectrum you want, depending on how powerful you want this incentive to be. But as long as you set this revenue trajectory ahead of time, then the utility immediately has an incentive to, across every business unit, find ways to spend less than that and save money. And in the case of Europe, where they've been doing this for a while because they were selling off publicly owned, bureaucratically run, inefficient utilities when they first started doing this, the main complaint was not that it didn't work, but they made way too much money because there were so many low hanging fruit to improve the efficiency of the utility that they had to kind of go back and quickly tighten the revenue cap down over time. And that's something you can build in automatically is this ratcheting down of the cap every three years or four years or five years. We reset it based on your actual expenditure over that period and your best practices and how they've evolved across the sector. And you can also build in a bunch of automatic adjustments to account for things that are outside the utility's control.

A (48:11)

Right.

B (48:12)

If you set that revenue cap thinking interest rates are 5% and they go up to 7%. Right. That's not on the utility. Right. And they should be able to pass that kind of cost through. So, you know, adjusting for inflation and interest rates is the most obvious one. But you could also account for demand growth or demand loss or other things like that automatically by adjusting this baseline. So then what the utility is getting is basically a trajectory with a formula that you know in advance for how it's going to update pending these sort of external factors that the utility doesn't control. And so that's the framework that is used broadly in Europe, actually in the UK and Spain and Sweden and a number of other countries, that has provided a much stronger incentive for the distribution utilities there to seek cost effective service rather than simply spend as much and capitalize as much as they can. So we should do that. I mean, it's easier said than done.

A (49:06)

Basically a budget, you're basically giving them a budget ahead of of time and then you're saying you got to stay in the budget.

B (49:12)

Yeah, it's just like the fixed price contract idea. Now there's a one obvious drawback that you might be thinking of if you think about a fixed price contract too, which is that the utility has an incentive to save expenditure and save money, spend less. But what if they do that at the expense of cutting corners? Right. Like the contractor at your house. Right. Oh, I'm running up against my fixed budget. I'm going to go put in subpar flooring or I'm going to put in fixtures that look fine but they fall out three days later after you move into your house. Right. And so you need to pair these incentives for efficiency, cost savings with performance based incentives for quality of service at a minimum and maybe other things that you care about too, like customer service or other qualities that we want the utility to provide. And so the typical initial formula was to pair this cost budget, you know, and trajectory with performance penalties and incentives for changes in the reliability of the network, things like the average duration and frequency of customer outages and other events like that, so that the utility has an incentive to think about reliability and balance that against efficiency and savings. And that works pretty well too.

A (50:17)

This sounds really interesting and I think we should do it. But I guess my one thought here is that it does seem to me too, as we look at the electricity inflation story, that the amount of infrastructure that is going to be needed, that is coming down the pipe like in western states, to manage wildfires everywhere to manage load growth, does somewhat defy the amount we might be able to rate base under current policy or at least. It just seems to me like there.

B (50:43)

Is going to be pressing the costs so high that people are going to revolt and we're not going to be able to.

A (50:48)

I haven't done a study to do this. I just feel like, just read the headlines.

B (50:53)

It looks like it's starting to happen. Right. People are pretty upset in California in particular, but in PJM here recently due to high prices from our wholesale markets and, and you know, yeah, people are upset with higher bills.

A (51:04)

Yeah, exactly. And the only way, I mean I. But I think it's also, I think getting to the wholesale markets is a good point. Is that basically, yes, we're talking about TND cost, T and D costs are going up, but at the same time we are experiencing higher electricity shocks because there is not an electricity shortage per se, but there's more demand for electricity than there is supply. More pressure and more pressure and that is going to be relieved by building more power plants. And the public's desire to have more power plants come online may exceed the market's willingness to fund those power plants. And it just seems to me like we should start talking about either financing new generation through the tax base or what New York is doing where the New York Power Authority is going to look into building a new roughly 1 GW scale Nuclear power plant upstate to manage Funded through, through programs that are not necessarily power rates themselves, but through the more progressive tax base to manage the surge in spending, surge in electricity demand that we think is coming.

B (52:08)

Yeah, I mean, so the incentives I'm talking about wouldn't apply in the case of competitive generation, but could apply in the case of government owned or regulated monopoly generation assets and the T and D assets, which are also regulated monopolies. And I should be clear, like the revenue cap doesn't have to be going down, it can be going up because we expect the utility to be making investment to accommodate demand growth and wildfire risk and these kinds of things. It's just once you set that, they have an efficient incentive to do it cost effectively. So that would help mitigate the pace at which we're going to have to increase costs. But it's not going to say we don't need to invest in the grid anymore necessarily. But what you're saying is I think a couple other options that we have, which is we can use government financing or other subsidy to lower the cost of capital. Right. Because again, we're allowing this return on investment. You still get a return on investment under the incentive regulation approach too. It's just adjusted based on how much you end up spending. And if the public markets have a certain price and the government can undercut that by a couple percentage points, that's a meaningful decrease in the mortgage you have to pay on the all the capital that we're going to expend. Right. And so that would be something to explore. We did that in the 1930s, right. To electrify rural America. We took out a bunch of government bonds and built the dams and electrified the countryside. New York State still has nypa, the New York Power Authority as a vestige of that era. And so it is able to, as you mentioned, look into the use of NYPA as an alternative way to finance some of these investments with government bonds. The federal government could do the same. We could ramp up the federal power and marketing authorities to do it more than they already do. We could create a new National Transmission Authority or National Distribution Financing Authority or something like that to lower the cost of this. The federal Loan guarantee program actually was doing that for several projects, some of which, like the Grain Belt Express Transmission line were just canceled by this administration. So that's one option. Lower the cost of capital by basically providing access to lower cost debt or even equity in the form of bonds from the government. The second option would be to take, take some of this cost out of our bills, whether we're paying for that at a publicly owned utility or a private utility and put it on the tax base. Basically say we're going to directly spend this out of the government revenue, the general fund, and build something without having to put all that cost on the rate base. That's what the tax credits in the Inflation Reduction act were doing for wind and solar and storage and you know, not so much for transmission or distribution. But yeah, so we still have some of those. So that's important to keep that in mind. Like that's basically what they're doing is they're shifting cost of meeting growing demand out of the rate base, out of your customer electricity bill and onto the tax bill. And because our tax code is at least somewhat progressive still rich people pay more, a larger share of that than middle class and poor people. And so we might think that might be a more fair way to do certain spending. Right. That's how we pay for the public libraries and our schools and even a good chunk of the roads that we drive on these other kind of utility functions or public goods that.

A (55:11)

And not only does it go through the tax base, but then the government can access, it can access the government rate of finance.

B (55:17)

Well, not necessarily. It could. Those are two separate things, right. I can provide a government backed loan guarantee or loan to a private utility, or I can give a direct subsidy to a private company, or we can combine them and the subsidy expenditure goes to a publicly owned utility. Those are all independent options. And, and I think that's important because in places where we don't have a nypa, which is most of the country, you could still use government financing and government subsidy to offset some of these costs. Now I think that what that raises is what the appropriate question is like. Do we want to undercut private finance everywhere? The sort of classic question about crowding out or crowding in investment. But the other bigger question I think for the tax shifting things to the tax base is what is appropriate to put on the tax base versus users. Right. What do we want to socialize amongst taxpayers? And you don't want to do that. Everything but certain expenditures like delivering cleaner energy. The public good aspect of that, I think building a more resilient grid that doesn't fail in the face of hurricanes or wildfires or extreme flooding events that are likely to come. There's a public good nature to that that we should probably broadly subsidize in some form or another.

A (56:26)

But it does rapidly get tricky because I think the public has an interest in a cheap and abundant electricity grid. However, we don't want that to then pay all this, use all this public money to build out the grid and then watch bitcoin miners like suck up all the excess electricity. I mean, there is in fact a way you can use electricity that is completely privatizes all that.

B (56:46)

Exactly.

A (56:47)

Yeah.

B (56:47)

So it's a tricky question, but yeah, I think that's the solution set we basically have though, right. Is changing the utilities regulations. Right. The contract we've struck with the utility so that they have a broader incentive to save money when it is possible and be more cost efficient and to balance opportunities to spend money on operational expenditures like contracting with distributed energy or demand response as opposed to building more copper and wires and transformers to lower their cost of capital, either by tightening the allowed return on investment in places where that's gotten out of step with the market, or by shifting to government backed financing which has a lower cost of debt and equity, or shifting some of these costs onto the tax base and out of the rate base. I think that's basically the universe of solutions we have at our disposal there.

A (57:32)

Well, let's leave it there and when we come back, we'll do upshift downshift. And now it is time for Upshift Downshift, our weekly look at current events in climate energy where Jesse Knight pull one news item from the vast world of climate and energy news or from news overall and share whether it's making us feel more upbeat or downbeat about the energy transition. Of course, if it's making us feel more upbeat, it's an upshift. If it's making us feel more downbeat, it's a downshift. Jesse, what do you have for us?

B (58:07)

Well, I guess I have an upshift followed by a downshift that's going to lead to an upshift. So this one's a little bit of a costume. So the upshift is that China first half of 2025 installed 212 gigawatts of solar projects across the country. 212 gigawatts in six months. Like our entire grid here in the United states is like 1.2 terawatts or 1200 gigawatts. It's like an enormous amount of additions in just six months. I should have done the math on how many megawatts per minute that is, but it's a lot. However, that's partly a rush to complete projects before a set of power market reforms that will expose solar projects to basically wholesale electricity prices and move them off a fixed price tariff that they currently receive. Basically, as I understand it, solar today has paid the avoided cost of coal generation at a fixed price. And what China is recognizing is that with this huge amount of solar capacity in the system, some hours you've got more solar than you need and you're curtailing it and it's not as valuable as other hours in other places. And so they're trying to provide more market based signals to solar developers about where to build and when to generate power. They're doing this for wind power and other generators as well. This is good market economics moves the market in China much more similarly to what it is in the US but it does add more uncertainty and potentially reduce the revenues that solar developers are going to earn there. And so that leads to the downshift, I guess, which is that it analysts are expecting that solar installations will stabilize in China at about 250 gigawatts annually in 2026, right? Versus they already built 212 gigawatts in just six months this year. Now saying only 250 gigawatts of annual solar installation is a downshift. It just shows you the scale and pace at which China is building out solar. But what that does mean is that the oversupply that Chinese solar manufacturers are already struggling with with will get even worse, right? They can produce something like 500 gigawatts of solar panels on that order. So more than twice as much probably as the Chinese domestic market is going to need after these market reforms. And so that's going to be difficult for solar manufacturers and their profit margins. But what the other ripple effect of that is that it's going to drive, I think, a lot more export of solar PV around the world. And that's where the upshift from this downshift comes in, which is that we're already starting to see record numbers of solar panels deployed and purchased in lower income African countries, in Pakistan and other parts around the world that are eager to buy these cheap solar panels. For example, I've heard recently that where they have waived duties on solar PV imports and now all of a sudden they're deploying record amounts there as well. So this kind of flood of cheap solar PV around the world I think is going to be a feature of the next few years as China's manufacturing capacity starts to adjust to the changes in its domestic market. And then to add to that, India also just announced that it was going to lower value added taxes or goods and service taxes on both solar modules and wind turbine generators, cutting it from the current 12% rate, which is kind of broadly applied to Most products under 5%, which analysts expect will lower the cost of wind and solar projects by about 5% in India and help drive more deployment in India as well. I think think India itself is balancing with whether to build its own domestic solar manufacturing capacity up or to just simply accept this flood of cheap imports from their neighbors in China. But in any case, this reduction in the tax rate is also going to help drive more solar and wind deployment in India. So we've got a lot of depressing news and downshifts from the United States context. But I do want to zoom out whenever possible to note that China and India, the two world's most populous countries, continuing to move down this path and cheap solar panels now being able to spread around the world to lower income countries that have just been off the map so far in terms of the global solar market, are now buying gigawatts of panels and deploying them in places like Algeria and Morocco and elsewhere.

A (62:11)

Well, that's funny because I also actually have an upshift here. I mean, look, there's a big downshift that I want to allude to briefly, which is that this completely counterproductive Trump administration immigration raid on the Hyundai battery plant in Georgia, which rounded up 475 people, shackled them at the factory, most of those people being South Korean nationals, and has caused a complete diplomatic row with South Korea. And I want to highlight it because the US incentivized, if not pushed for South Korea to build factories here. It is a stated goal of the Trump administration. They sent engineers to teach us how to build batteries and how to build technology. Technology that by the way, a military context the Trump administration is quite clear that we need. And then once they were here, shackled them up and completely humiliated them, it is counterproductive in every way. It is going to set back America's ability to regain manufacturing know how if you look at batteries, if you look at electric vehicles, if you look at any kind of sub component of making batteries, cells, anodes, these are industries absolutely dominated by China. And the number one country after China that has any expertise here and any market share to speak of really that is worth mentioning is South Korea. So if we want to do these things in the US we will learn from the South Koreans. And what the Trump administration has just done is shackle them up. It's a total scandal, really unconscionable against exactly what the President says he wants his goals for the economy to be other than humiliating anyone who comes here who isn't white. That being said, I want to actually highlight an upshift, which is the second part of your upshift, Jesse, which is this new Ember report, a new report from the think tank Ember that came out yesterday on September 9th that makes a broader case about China's emission shift and argues that its electrification and its rising solar and wind power is right now actually doing the thing that we've all suspected it would be doing, which is driving down fossil fuel use. And it pulls on two different variables for that. The first is that between 2015 and 2023, China's fossil fuel use in the buildings, industry and transport sector fell by 1.7% while electricity use rose by 65%. And then just in the first half of this year, its fossil fuel use in the power sector dropped by 2%. And that's been driven by just as, Jesse, as you were saying, absolutely roaring build out of wind and solar infrastructure. Wind has risen by 16% in. Solar has risen by 43% in terms of generation during the first six months of this year. In the 12 months from June 2024 to June 2025, wind and solar generated more electricity than hydro dams, nuclear or BioEnergy did just four years ago. So in 2021, like at the beginning of the Biden administration, wind and solar were half of hydro, nuclear and bio in China and now they generate more than hydro, nuclear and bio in China. Like China has actually built out its wind and solar and is driving down its hydro and nuclear and bio. Now, of course, what we wanted to do is drive down coal, but I think part of the implicit argument here is that this will eventually work to drive down coal as it's driving down other sources. China is the biggest story in the world. This is the biggest story happening in the Chinese energy economy. I feel like people haven't really reckoned yet with the fact that a lot of things that we wanted the United States to do in energy and climate policy, China has now done. And that when the US Returns to a standpoint of making energy environmental policy, it will be catching up to China and China will be the leading provider of manufactured energy services to the the of rest. Rest of the world. It already is, but it will be further entrenched in a way that I don't think really any climate policy as it was formulated in the US from say 1995 to 2022 was really prepared to reckon with.

B (66:14)

Yep.

A (66:15)

It's just a totally different world.

B (66:16)

Yeah. The good way to put it, Yep.

A (66:19)

Right now the US really isn't doing climate policy, so it's not something we're talking about. But I think we hoped the US Would play a lot of different roles in the global energy transition, and it's not really going to play them. And China is going to to play those roles. And now the question is what the US does to maintain some bare form of economic competitiveness along with its allies. I think we'll talk about that more in future episodes of Shift Key. For now, though, I want to thank you for listening to Shift Key today. You can follow me on X at Robinsmeier or Bluesky or LinkedIn under those names. Jesse, where can people find you?

B (66:48)

They can find me on Twitter or RIP x.com essiejenkins they can find me on Bluesky at @jesse djenkins.com and on LinkedIn as well. So see you all there.

A (67:00)

If you enjoyed Shifts, you can leave us a review in your favorite podcast app. You can email us @Shift KeyAtMap News Shift Key is a production, in fact, of Heatmap News. Our editors are Gillian Goodman and Nico Boricella. Multimedia editing and audio engineering is by Jacob Lambert and Nick Woodbury. Our music is by Adam Cromwellow. Thanks so much for listening and see you next week.